Timing is crucial for some ETFs

In a market correction, the seemingly "correct" thing to do would be to bet against the market.

There are a lot of ways to do that, but perhaps the easiest, most straightforward was would be with something like the ProShares Short S&P 500 (SH) or UltraShort S&P 500 (SDS) exchange-traded funds.

But for investors ready to take that step and go against the market right now, fresh off a few weeks of nervousness and decline, they’d be making the Stupid Investment of the Week.

Stupid Investment of the Week highlights concerns and conditions that make a security less than ideal for the average investor, and is written in the hope that showcasing danger in one case will make it easier to avoid trouble elsewhere. While obviously not a purchase recommendation, neither is the column intended as an automatic sell signal.

Picking on the inverse Standard & Poor’s 500 funds is not a market call — because there is far more evidence the market will be flat or lackluster than that it will turn strongly positive from here. It’s rather a matter of an average investor making an ill-advised move at the wrong time.

SHORT STRAW

Betting against the market has become increasingly easy with the advent of exchange-traded funds. In the days before ETFs, an investor who wanted to profit from a market decline would engage in short sales, borrowing stock from a brokerage firm and selling it on the open market. If the stock subsequently declines in price, the shares can be repurchased at a lower price, returned to the brokerage and the investor keeps the difference.

For an average investor, however, the first steps toward shorting tended to be harrowing. Investors bet on stocks going up all the time and can sit still for days, weeks or years and ride out market volatility, but there’s something different about being in a short position, owing the shares plus interest back to the house. For many average investors, that uneasiness was why they could never get comfortable betting against a stock or the market.

ETFs completely changed that, because even a fund that shorts the market is purchased the same way as a long investment, where the consumer is betting on a market increase. It makes it emotionally easier for average investors to short the market, which makes it easier to play hunches or to try to cash in on short-term bets on where the market is going.

That’s where the average investor goes wrong with the ProShares funds.

The funds are built to deliver the inverse of the market — or double the inverse of the market in the case of the UltraShort fund — on a daily basis, but they actually fail to deliver that return over time.

DANGEROUS LEVERAGE

It’s easy to see why, particularly when you look at the leverage involved in the UltraShort fund. We’ll use round numbers to show why. You invest $10,000 in the ETF and the first day the market goes against you and gains 5 percent; the fund loses 10 percent that day (double the fund, in the opposite direction). The next day, the market "corrects" and reverses course, giving back that 5 percent. The fund moves 10 percent in your favor.

The market, after two days, is nearly right back where it started. You’re not.

When the fund lost 10 percent of its value, your holdings dropped to $9,000. When it gained 10 percent on the second day, your account added 10 percent of that lower amount, leaving you with $9,900. (That’s before the fund’s expenses are factored in.) So most observers would say the market was flat, but you lost 1 percent in two days.

You might think you can reduce that impact by sticking with the short fund. Not to bore you by crunching the numbers, but an inverse fund that simply shoots to do the opposite of the market still has the effective leverage of a fund looking to double that number. It also uses the daily rebalancing, so investors still are dealing with leverage and daily compounding, issues that make leveraged ETFs inappropriate for most average investors.

"The issue that I have is in using the term ‘investing’ with a leveraged product," said Scott Burns, director of ETF analysis for Morningstar. "We typically view these products as trading vehicles and, if you are going to hold them long-term, they will require daily vigilance and capital for rebalancing, as well as the discipline to take money off the table when things go your way."

Moreover, while the junk rally — the big rise in stocks with lousy fundamentals — may be unwinding now, many observers think there will be a subsequent rise in quality names, pushed ahead by solid earnings gains. That leaves the average investor with plenty of danger if they have made a bad call.

Mark Salzinger, editor of the Investor’s ETF Report, noted that ProShares Short "went from a peak of $115.09 in early March all the way down to as low as $32.84 earlier this year. That’s a loss of more than 70 percent. Any ‘investment’ that can lose that much in less than a year — or for any period — definitely qualifies as ‘stupid.’ "

In the end, however, the biggest factor for investors is that the urge to make the change and bet against the market only occurred after the market took a big step backwards and tested a big milestone, such as the Dow’s 10,000 mark. That means the average investor is late to the pity party, and is instead chasing returns.

The market isn’t "incorrect" when it goes up. In fact, corrections can work both ways. So if a short fund like ProShares Short S&P 500 or UltraShort S&P 500 seems the correct thing to do right now, you may want to revisit your thinking, because if your judgment is late, faulty or incorrect, you’ll pay a big price.